Wednesday, August 12, 2009

Downward sloping demand curves (?)

A while back on this blog there was some discussion of the nature of the demand curve in economics. I claimed that economists rather dogmatically insist it is downward-sloping. (To be sure, it had once been a matter of considerable debate, but views seem to have hardened on it post WWII.) Anyway, recently I was emailing with a bright economist PhD student, David Wiczer, at Illinois. He recounted a discussion he had with a co-author (it has some jargon but the main point should be clear enough):"We were pretty convinced that it implies we can’t just estimate reduced form models and expect the coefficients to stay fixed, that is the same negative slope on a demand equation doesn’t hold between different contexts, but beyond this, we were pretty unsure where to go. Finding “true” forms for these relations is fraught, as exemplified by a debate right now about how labor and output respond to news of productivity increases. On the one side, a set of models has it the people work more because new technology makes their wage go up, on the other there’s an effect that labor input goes down and there’s a recession because some friction either in the firm’s demand for labor or household demand for leisure (i.e. supply). I guess the point is that these demand and supply curves are very difficult to pin down, and our understanding the data that should suggest their form is itself in flux. There’s a nice line a Francis Ramey paper on the subject, discussing the proper model to study technology shocks and business cycles:“It is interesting to note that the first of these models had been previously dismissed in the literature because the implied negative correlation between technology and labor was ‘counterfactual.’ The previous empirical results [their VARs] suggest that the model’s predictions are completely in line with the ‘facts.’”As a student who’s spent most of his life receiving truth and wisdom put on a chalk board, this is an exciting realization: not only am I ignorant, but so is everyone else."

So, I am glad to correct myself: there is empirical discussion of the demand curve in economics (again). These are exciting times to be following the economics discipline. Because of the implosion of financial markets last year and the recession based on it, there is a lot more willingness to question foundational principles.